Don’t go Chasing Waterfalls

A waterfall in real estate investing is a legal term used in a sponsors operating agreement that defines how distributions and profits are paid, when the money is paid, and to whom the money is paid.

The cash flow from distributions and the profit split paid to investors at the time of a capital event (cash out refinance or sale of property) are allocated to the general partner (GPs) and limited partners (LPs) according to the waterfall structure outlined in the sponsors operating agreement. For purposes of this writing, the GP can also be defined as the “sponsor” or “operator,” and the LP can also be defined as the “passive investor.”

Understanding the waterfall structure is important to the passive investor because the waterfall may be determined based upon different sponsor methodologies that impact the actual return to the investor. The terms offered may also be different for each investment made.

A common example of a waterfall structure may be a sponsor who offers an 8% preferred return and then a 75%/25% split on profits (paid to investors at the time of a capital event). In this example, and after all operating expenses have been covered, passive investors should expect to receive an 8% cash return on their investment. In most syndication deals, the cash on cash distributions are paid out to investors monthly or quarterly.

After the preferred return waterfall “bucket” has been filled, remaining distributions and profit splits will be paid to the GP and LP according to the next waterfall “bucket” outlined in the operating agreement. In this example, the LP will receive a 75% split on remaining distributions and profits and the GP will receive 25%.

To simplify this point, let’s assume that at the time of desposition (sale of asset) the property generates a $10mm profit. 75% of the profit will be paid to the LP’s and 25% will be paid to the GP’s. The LP’s share of profit is paid according to the percentage of equity ownership they have in the investment. When you passively invest into a real estate offering, you receive “shares” and those acquired shares will determine your ownership level and how profits will be paid to investors when the deal goes full cycle.

Let’s address a few common questions:

• If the 8% preferred return is not reached (mostly due to some investments taking a year or more to “reposition”), does it carry over (accrue) to the next year? In most cases, the preferred return is cumulative and the passive investor would be made whole at the 8% cash on cash preferred return. This language will be outlined in the sponsors operating agreement.

• Are all waterfall structures the same? No, each sponsor offers their own waterfall structure according to the sponsors underwriting assumptions and economics of the property being acquired. The terms offered are often based upon other comparable investments in the market and the expectation the project will reasonably reach the return that the investor deems is a good risk-adjusted return relative to other investments.

• What if the preferred investor return is not reached? Passive investors must assume the risk that a real estate investment may not reach the preferred return projection offered by the sponsor. However, if this occurs the sponsor will also not achieve their profit split. The primary purpose of the preferred return is to put the passive investors interest first over that of the sponsors. After all, it is the passive investors capital that is at risk.

Waterfall structures are often not easy to model out since each investments economics are different and each sponsor may have a different projected outcome.

The success of any passive investment can be different for each investor, according to their own risk tolerance and overall investing goals.